Tax Rules on Cashing in a Roth IRA

by Mark Kennan

Sometimes you find yourself so short of money that you consider tapping into your retirement accounts to get by. Knowing how the Internal Revenue Service treats cashing in a Roth IRA helps you decide if a withdrawal is in your best interests, or if you are better off figuring out another way to pay your bills.

Qualified Distributions Defined

A qualified distribution from a Roth IRA allows you to take out all the money without paying any income taxes or penalties. To qualify, your Roth IRA must have been open for five tax years. The tax years start counting from Jan. 1 of the first tax year you made a Roth IRA contribution. In addition, you must either be 59 1/2 years old, permanently disabled or taking out up to $10,000 for a first home purchase. For example, if your Roth IRA has been open for at least five tax years and you are permanently disabled, you can take qualified distributions. However, if you are 65 years old but your Roth IRA is only two tax years old, you cannot.

Figuring Early Distributions from Roth IRAs

When you take a non-qualified distribution, any distribution for which you do not meet the criteria for qualified distributions, your Roth IRA is divided into two components: contributions and earnings. First, you cash in all of your contributions. When you do so, you do not pay taxes or penalties because you already counted the contributions as taxable income in the year you made your contribution. After cashing in all your contributions, you take out the earnings, which count as taxable income and are subject to a 10 percent early withdrawal penalty.

Avoiding the Roth IRA Early Withdrawal Penalty

If you do cash in Roth IRA earnings, you can avoid the early withdrawal penalty, but not the income taxes, in limited scenarios. For example, if you suffer a permanent disability or have medical bills that exceed 7.5 percent of your adjusted gross income, the IRS waives the early withdrawal penalty for earnings. The IRS also waives the early withdrawal penalty for earnings distributed to pay for college expenses or health insurance premiums while you are unemployed. In addition, if your Roth IRA is less than five tax years old, you can avoid the early withdrawal penalty on up to $10,000 of your distribution if you use it for a first home purchase. Beware that your spouse must also qualify as a first time home buyer if you are married.

Tax Reporting of Cashing in a Roth IRA

Cashing in a Roth IRA requires that you report the distribution on your income taxes, even if you do not owe income taxes as a result. Filing Form 8606 documents whether you removed contributions, earnings or both. Form 5329 documents the size of your early withdrawal penalty or why you are exempt from paying it. Finally, reporting the amount of the taxable and nontaxable portions on your taxes allows the IRS to track how much you took out and, if you took out a taxable amount, how much income tax you owe as a result.

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